Branko Milanovic: 5 powerful forces driving income inequality

ByBy Branko Milanovic

May 15, 2016

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Income inequality is driven by both political and economic forces and it waxes and wanes over time. In my new book, “Global Inequality: A New Approach for the Age of Globalization,” I introduce the concept of Kuznets waves to describe this rise and fall.

The name comes from the famous American economist Simon Kuznets, who in the 1950s and 1960s argued that as societies underwent the Industrial Revolution they become more unequal, with labor moving from agriculture to industry. This is followed by a period of declining income inequality as highly educated labor becomes more plentiful and social transfers increase. So it seemed that the rich countries were destined to become more egalitarian and stay that way.

But Kuznets’ theory ran into trouble in the past three decades as inequality rose in almost all developed countries, with the technology revolution playing the role of the Industrial Revolution and labor moving from well-paying manufacturing to less-remunerative services. Thus the broad forces pushing up U.S. inequality remain dominant. There are five specific forces to consider:

1. The increasing share of national income that accrues to owners of capital.

2. Very high and rising concentration of incomes from capital.

3. People holding high-paying jobs also often have high capital income.

4. The tendency of high-income individuals to marry each other.

5. The rising political power of the rich.

The pattern of capital claiming a larger share of national income is a well-documented phenomenon in many countries, including the U.S.

In a recent paper, economists Loukas Karabarbounis and Brent Neiman show that capital’s share of U.S. net income increased from about 33 percent in 1975 to 37 percent in 2012. This is a new development because it was generally assumed that capital and labor income shares are fixed over the long term.

This was deemed so obvious that relatively little empirical work was dedicated to the issue. The main reason for the recent increase is that as the price of capital goods declined, companies used ever-more capital — more than enough to make up for the decline in price. A continuation of this trend seems likely, as machines keep on replacing workers and further erode labor’s income share.

If capital ownership were evenly distributed, the rising share of income from capital wouldn’t be a big concern. However, in all modern societies capital ownership is heavily concentrated.

In principle, a “deconcentration” of capital ownership would go a long way toward defusing the problem. But this isn’t anywhere on the horizon. Data from economist Edward Wolff indicate that concentration, instead, is increasing. In 2007, 38 percent of all stocks were owned by the wealthiest top 1 percent of individuals; the top 10 percent owned 81 percent of all stocks; and both represented an increase from 2000.

Another impetus to rising inequality comes from a tendency, documented by economists Christoph Lakner and Tony Atkinson, for people with high income from labor to also have high income from capital. Atkinson and Lakner show that the likelihood of a person who is in the top 1 percent by labor income being in the top decile by capital income has increased from less than 50 percent in 1980 to 63 percent in 2010.

The reason for this is that people with very high earnings save a sizeable portion of their income, which then generates investment income. It’s also easy to see how this kind of inequality can become entrenched, with parents investing in their children’s education, enabling them to get highly paid jobs while also inheriting large amounts of capital. People with high incomes both from labor and capital enjoy greater stability and less risk. At the same time, because of their educational attainment, they benefit from the perception of merit, which makes such inequality politically more difficult to tackle.

The next factor is the tendency of the highly skilled and educated, and thus generally rich individuals, to marry people with similar characteristics. In the 1960s, when relatively few women worked, it was common for well-off men to marry women who didn’t work outside the home and wouldn’t contribute a monetary income. This tended to diminish inequality. But as economists Jeremy Greenwood, Nezih Guner, Georgi Kocharkov and Cezar Santos document, during the past quarter-century Americans increasingly marry people like themselves. A welcome change in social norms that has seen the soaring labor participation of women and encouraged marriages based on similarities of interests and backgrounds has paradoxically led to an increase in income inequality. This trend may well persist, as the gap in both educational achievement and labor-force participation between men and women disappears.

Finally, we come to the fifth element that makes the reversal of inequality particularly difficult: the growing importance of money in politics. People who make major contributions to political campaigns are, by definition, rich. They also receive a return on these political investments in the form of influence and favorable policies. To believe otherwise isn’t simply being naïve; it goes against the key principles of economics and common sense. The rich didn’t get that way by throwing money around without expecting a return on it.

As documented by political scientists Larry Bartels and Martin Gilens, U.S. senators and representatives are much more likely to address the concerns of their rich constituents than poor constituents. Gilens, for example, showed that policies favored by the rich have a much greater probability of being acted upon and adopted than policies about which the poor and the middle class care.

These five developments, which all aggravate U.S. inequality, make it hard to see where the offsetting forces would come from. The economic logic of the rising share of income going to capital is reinforced by the way that high incomes from capital and labor are distributed, by social norms and finally by economic policies. It is this unusual confluence of factors that seems likely to keep inequality high for the foreseeable future.

Branko Milanovic is a visiting professor at the City University of New York’s Graduate Center and a senior fellow at the Luxembourg Income Study Center.